Three kinds of 4%

Nowadays you don't have to buy an annuity with your pension pot - you can invest it and draw an income instead [often known as income drawdown]. This pot can still be used to buy an an annuity later [up to age 75] if you want.

So how much can you safely withdraw each year? Well the answer depends on your life expectancy and your future investment returns. Both are very uncertain, so much attention has been given to finding the 'safe withdrawal rate' even allowing for poor stock market returns, and increased longevity.

The standard answer is around 4%.

But there are three kinds of 4% withdrawal on - say - a $100,000 pot. (We are talking dollars here because its in the USA that this has been studied most).

1 Take $4000 a year index linked. So it goes up with inflation.

2 Take $4000 every year - flat rate.

3 Take out 4% of your pot whatever its size.

Option 1 is the toughest to maintain, option 2 is usually what is meant by the 4% rule, option 3 is the 'safest'. Where safety means you will never run out of money (although you might run short of money).

The vanilla pensioner goes for option 3, despite its drawbacks which are:

• your income will bounce up and down with the value of your fund; and
• it doesn't allow for the fact that as you get older, you should be able to withdraw a higher percentage from your fund

We will look at ways to fix this, without straying too far from the underlying philosophy: the size of the pension you can take depends on the amount of money you have - not on the amount of money you used to have.

And that is the serious drawback of options 1 and 2 - blithely taking $4000 a year even though your fund may have dropped to $60 000.

Will half a million cover it?

This article puts the cost of retirement for a pensioner couple around £500 00 (£600 000 in London).

the average household needs £564,227 to cover the cost of the first 20 years after quitting the workforce. The calculation is based on annual household expenditure for those aged 65 to 74 at £23,107.

Quite what happens in year 21 of retirement they don't say. You'd think they'd know, especially as they can calculate expenses over 20 years to the nearest pound...

http://uk.finance.yahoo.com/news/couples-must-budget-600-000-for-retirement-tele-78e6abbbac10.html

Sweet seventeen

Think of a number and multiply it by 25. Thats a rough guide to the cost of an inflation linked pension. For a woman in her mid sixties, or a man a couple of years younger. So £10 000 pension will cost you £250 000.

Or if you want to retire on two-thirds of your salary, then multiply your salary by 17. That's how much you will need to save.

So what does it take to save an amount equal to 17x your salary? There's a lot of variables here - but it shouldn't put you off working out a ball park figure.

Let start by assuming you save two months of your salary, every year for forty years. And your salary stays fixed in real terms. Take real annual growth as between 1-4%: 1% definitely, 2.5% probably, or 4% possibly (with a lot of your savings in riskier shares).

What do you end up with?

Amount of salary saved after 40 years with growth of

1% 2.5% 4%

8x 11x 16x

So despite continual real growth of 4% for forty years and saving two months salary every year, you still come up short. Just.

Let's up the amount of savings to three months a year.

1% 2.5% 4%

12x 17x 24x

And suddenly we are there, even with only medium growth. With the high returns (4%) you can practically retire on a pension equal to your salary. (It will certainly feel like it, because you won't be saving 25% of your income any more)

But who saves three months money every year?

Shouldn't the government do something? Well they have - they have set the contributions level for the new default pension scheme (now called Nest) at around one months salary [employees pay half of it].

How much would that give you?

1% 2.5% 4%

4x 5.5x 8x

Saving one month's salary a year isn't enough. But the government obviously sees this as a glass half full. Tell people they need to save at least double that amount and they might become too dispirited to even try.

Bolton and vanilla

Hot fund in a hot sector. A friend asks 'I was thinking of putting money into Bolton's new China fund....'

I guess this is how most people begin. Not with boring, but sensible, asset allocation. But a punt on something a bit more exciting. He knows very little about investing. Is this really a good place to start? Surely it would be better to start by having half your savings in global equities and half in index linked gilts? Simpler and less risk.

But the reality is: savers don't start out as vanilla investors - and then move onto more complex savings instruments; they actually move into vanilla investing after having been stung, burnt, or just plain caught by surprise by the vagaries of real world investing.

Back to Bolton. The attraction is his fantastic track record at his Special Situations fund he ran from 1979. Hence the hurry to get into his new fund launching now. 'What do you think?' Hmm. Where to start.

First off: the three big savings choices are house [pay off mortgage]; ISA and pension [company plan or SIPP].

Then you can figure out how much you want to risk in global equities. Then you can have some emerging markets. A subset of that are the BRICs [Brazil, Russia, India China] - and finally we get to China on its own. 'So you don't think I should put all my money in it?' No.

'But the offer closes in a few weeks'. Well, you can still but the shares after the offer closes. 'Really. I didn't know that'. Yup, and then you can buy as little as you like - instead of being forced to buy a minimum of £2500. Or you could wait ten years and buy some then. 'Ten years! The people who bought Bolton's first fund from the beginning did fantastically well'. Yes, it did fine for the first ten years, but it was only in the early nineties, around 1992 that it really took off. And the first five years of its life gave little sign of the fireworks to come. Here's the picture.

'Well I can't risk that - Bolton may only hang around for a couple of years.' Some people would see that as a reason for caution. Besides, you may be able to pick the shares up at a discount.

'Discount?'

Ok, we'll deal with the discount later. Meanwhile I couldn't interest you in a global equites tracker?

'Nah. Too boring.'

Financial journalism

In today's Sunday Times

.... the American-educated prince [Alwaleed bin Talal] - described by Time magazine as 'the Arabian Warren Buffett' lives in a£180M palace with 317 rooms, 250 television sets and gold plated taps.

So, just like Warren then.

Buy losers, sell winners

Vanilla finance has a few very simple rules. They have been shown to work pretty well in the past. But they do have some big implications. 

Remember, the vanilla investor has to pick a mix containing both exciting [eg shares] and dependable investments [gilts]. Boring or bouncy? Whatever lets you sleep easy at night. 

Say you pick a 50:50 mix [the balanced portfolio]. When it gets out of line you will need to rebalance - maybe every couple of years. This will mean selling the asset that has outperformed, and buying more of the underperforming one. You sell winners and buy losers. 

Now buying into a losing share can be a recipe for disaster - because it could go to zero. (Actually this is true of winning shares too, its why we skip holding individual shares  in vanilla investing).  But buying into an asset class is not as dangerous.  The world global equity markets, taken as a whole, are not likely to hit zero [though there are no guarantees].

Let's look at what happened to Siobhan. She's saving £3000 a year into an ISA and had savings of £30,000, split 50:50 between gilts and shares. Held in a FTSE100 tracker and a medium-term gilts etf.

Siobhan has watched her shares drop 40% in value, her  savings are down to £24,000. To rebalance, she should now sell £3000 of her gilts and buy shares. This is tough. She has just watched two-years worth of hard saving disappear in the market falls. It feels like throwing good money after bad. 

So what did Siobhan do? Well if she just obeyed the rules, that would be that. But in the real world very few people do stick with a simple set of proven rules. Otherwise we'd all be vanilla investors.

First off , the 50:50 split turned out to be too scarey for Siobhan; 40:60  might have suited her better. Note that a portfolio should be tailored  to 'suit' your personality and circumstances more than market conditions. But Siobhan is enough of a vanilla investor to realise that buying when the market is low is better than selling. So she resists the temptation to give up on shares completely and sell out. She is saving for the long term, she is not going to change her strategy every time the market drops.

She still can't bear to sell any of her £15,000 of gilts though, which have been rock steady and such a comfort. So she compromises. She decides to channel all her dividends, interest and futures savings into the 'shares' side of her portfolio. She figures it will take her about 18 months for her monthly savings to push her current £9000 of shares back up to £15,000.

In fact the market rebounded. Within a year and [with the new money she was putting in] her shares were back and more - to  £17,000. Time to sell some shares  to rebalance ? No - selling £1000 worth to put into gilts is not economic, because of broker's commission and admin charges. Siobhan continues the strategy that suits her - any 'new' money [monthly savings, interest, dividends] she will now channel into the gilts side.

The rules on when to rebalance

'Every couple of years' sounds a bit vague, but in tests  its been shown to work ok. In theory rebalancing should happen when the portfolio gets out of balance. That's another simple statement with big implications: there is no timescale. Taken literally you could rebalance every day [big funds do this] or, if you wait for a major imbalance to occur years could go by before action was needed.

As a simple rule - if you have to top up a holding by 25% or more then do it.  If your 50:50 split slips to 40:60 then it is time to rebalance. In Siobhan's case suppose her portfolio grows to £40,000, of which £16,000 is in gilts. She should sell £4000 shares and invest in gilts to bring everything back into balance. That's a 25% increase in her gilts holding.

As ever - real life bends these rules a bit. Selling [especially shares] costs money - and should be avoided if possible. Instead, re-direct savings and interest flows. Don't forget, in the accumulation phase of your life [ie while you are working] you will be buying into asset classes over the long term. You will be buying more of everything. Selling is not normal.*

Finally, even the '25% top-up' rule should be ignored if you are only switching small amounts of money - say at the beginning of your savings career.  Steve has £3500 in shares, his plan says he should  have £2500. Is it worth selling £1000 of shares? In practice - no.

How much  is the minimum then? 

How long is a piece of string? But since you ask, and you want something practical and simple, and because all our other rules seem to have a a 2 and a 5  in them how about: £2500. 

As in - if you are buying and selling stuff over the long run - do it in decent-size chunks.  £1 is too little, £5000 is fine, and somewhere in the middle is the minimum you should aim for.

Yeah but why £2500 exactly?

It ain't exact, but its something you should be aware of. If  at 65 you look back over your savings career and your purchases have been in chunks of £500 rather than £5000, then commission and charges will add up. Seriously. If you aim to keep purchase costs under 1%, and you get charged £12.50 a trade, and stamp duty is 0.5% then the minimum size order turns out to be......

£2500

Yup

But what if there is no trading charge or stamp duty?

I remember some Irish based funds didn't pay stamp duty, and brokers offering special deals - effectively zero charges if you bought an Irish-based etf.  But you can't get round the spread.

Spread?

Even with zero charges if you buy something and sell it back immediately you will have lost money. Because of the difference between the buying and selling price. The spread. Vanilla investors resist making trades incessantly. Charges are one reason, the spread is another. The third is... oh, we'll save that for another time. 

Let indolence by your watchword.

*For pensioners [de-cumulators] 'buying'  to rebalance is not normal as you are taking money out of your portfolio to provide an income. Here adjustments are made by changing where these cash flows are coming from - taking more from gilts, or shares; and selling holdings over the long term. Rebalancing by 'buying' is the option you would look at last. Just as rebalancing by  'selling' is what you avoid as a saver. Remember to change your mindset when you retire.

OUCH!

Its the small print that carries the big news.

I am looking at a Hargreaves Lansdown sales letter that suggests I buy Artemis Strategic Assets fund. In small print is the bit about expenses.

Imagine it grows at 6% for ten years, with inflation at 3%. Unspectacular, boring even. But if you have just been hit by a 30% drop in share prices it could look quite attractive.

You give them your £1000. Now their calculations show that you might get back £1420 after ten years, after deducting £366 in expenses. Hmm. Your money has 'grown' by £788, and you get to keep £420 of it. They [the finance industry, not just HL] get the rest. This is terrible. And here's why - inflation.

After 10 years you need £1344 just to keep up with inflation. The 'growth' in your savings (in tomorrow's devalued pounds) is actually £447 - and they get to take £366 of it. Three quarters of the growth in your savings they take.

And finally it gets worse - you could invest your savings in government index linked bonds (say at 1%) then you end better off after ten years, with virtually no risk.

You have allowed someone else to take a bet with your money. They reap the rewards, you take the risk.

How do they (the industry) get away with it? HL are doing nothing illegal. They are not unusual in this. The 6% example is standard across the industry sales literature. The annual charge of 1.5% is also pretty standard (implying it costs £150 000 to run a £10million fund, but it takes £15million to run a billion pound one. Discuss).

The figures I have added in (1% real return for government bonds, and 3% for inflation) are not outrageous. Changing them changes the outcome - but then so would changing that stately 6% growth every year for ten years.

And that may be the answer. Year on year changes of 6% are rare; annual share price swing are much greater. Up 20%, down 25% and the ordinary punter (you and me) feels that within this context the odd 1.5% is neither here nor there.

Well it is.

By the time you work out your average net return over ten years, and then work out the return after inflation - and then you work our what you could have got completely safely with gilts - suddenly that 1.5% becomes a very big chunk of what is left. In many years its all of it.

And don't forget, you are being charge a premium on the assumption they can outperform the market (otherwise why not just hold the FTSE100). So even when the market massively outperforms gilts, they still haven't earned their money if they haven't outperformed the market.

How to fix this? How about if funds only charged if they outperformed the market,*  and only then on the portion of outperformance. If you have an active  fund manager (and I hope you don't by now) why not write and ask them whether you can switch charging regimes, and how much their fees would be. Let me know how you get on.

frequently unasked questions

When I do the calculations, ten years of index-linked is still a few quid behind the Artemis example; are you wrong?

Index linked money is todays pounds, you have to multiply by the inflation factor (here its 4/3) to turn it into tomorrow's money (£1 now has the same purchasing power as £1.33 in ten years time). Try it, and you really will wish you had stuck with gilts.

But at least with shares I stand a chance of making bundles

Yup. You'll win some, and you'll lose some. But win or lose the finance industry still gets your money.

It's a bit like estate agents - house prices may go up or down but...

Estate agents get their commission once when you buy/sell.... financial advisors go on getting it year after year. Even if you don't move or change your holdings at all for the rest of your life.

So I should buy individual shares to avoid the charges?

No - too risky. Buy collective investments like trackers and etfs

But they will still charge me won't they?

Yes. Maybe 0.5%, maybe less if you search hard enough.

But saving 1% a year... is that really worth it?

...sigh

*Even that is not a solution. Because they are smart, fund managers would then start making enormously risky bets with your capital. The winners would make them bundles, the losers they would never have got any commission on anyway. Under this system, the size of your loss would not impact on their fees.